Brazil's Central Bank Takes Action As Economic Outlook Worsens

Brazil's Central Bank injected another $12 billion into the economy on Wednesday following analyst projections that this year's GDP will print at just 0.79%.

This is the second time the Central Bank has provided some form of stimulus to lenders. In July, it provided around $21 billion to banks to induce lending.

Brazilian equities have been on a tear lately no matter what the economic fundamentals suggest. The iShares
MSCI Brazil (EWZ) exchange traded fund is up 6.07% in the past five days, clobbering the benchmark MSCI Emerging Markets index by roughly 500 basis points.

Most of the action in Brazilian stocks, however, has been driven by speculation that president Dilma Rousseff will take a cue from her presidential challengers. They hope she returns to a more orthodox way of handling the economy if re-elected, as polls currently suggest. The market has not taken kindly to Dilma and Finance Minister Guido Mantega's tinkering, primarily through a number of macro-prudential measures used to lower taxes and inflation while keeping interest rates artificially low.

Brazil's Central Bank allows for lenders to expand credit, hoping to inject some R$10 billion into a sluggish economy.

It didn't work. Inflation remained persistently high. And even with low interest rates, Brazil's GDP growth averaged under 2% over the last two years.

Investors have been pushing equities higher not because of Central Bank stimulus but because the market expectations for a policy shift regardless of the winner in October is keeping things bullish.

On Wednesday, the Central Bank allowed for lenders to use up to 60% of the amount of money deposited by clients to lend to second parties, or to acquire diversified portfolios such as money market and savings accounts. Prior to today's change it was 50%, and in July it was 20%. The measure, in theory, could inject up to R$10 billion ($4.8 billion) into the economy.

For now, Brazil equities are dependent on investment sentiment surrounding the October elections. Quarterly growth forecasts and other economic data is secondary.

Nicolas Jaquier, an emerging markets economist at
Standard Life Investments remains cautious on Brazil fixed income. "A change in economic policy will be bullish for bonds," he said. That's because if Brazil is to get serious about keeping inflation under 6%, it will have to raise interest rates. Higher rates means higher demand for local currency bonds, which will push on bond prices for new debt.

Marcelo Salomon, a senior Latin America economist for
Barclays Capital in New York, said in a note to clients this week that equities in energy and finance would also gain from changes in government policy.

At this point, market consensus agrees with pollsters that Dilma will be re-elected. But if she wins, she will likely make policy changes that keep the market happy. Brazil's growth has been relatively stagnant since she took office. In 2011, her first year in office, Brazil's GDP totaled $2.14 trillion. In 2012, it rose to $2.4 trillion, but declined to $2.24 trillion in 2013 and is expected to come in close to that this year, according to World Bank estimates.

Dilma has not been kind to Brazil's stock market.

The iShares MSCI Brazil ETF dropped 34.06% since her inauguration on Jan. 1, 2011, while emerging markets in general declined by 5.4%. Brazil has been the worst performing BRIC equity market since Dilma took office.